Banks hold too few assets, while credit remains scarce.

In a new report, the IMF has warned that the pressure on European banks to deleverage could jeopardise wider stability in the continent, and forestall a recovery before it has even begun.

The April 2012 Global Financial Stability report highlights the competing pressures on individual banks and the system as a whole. For banks, the fund warns that "weak growth and high debt repayments" are forcing banks to "strengthen their balance sheets by reducing assets and increasing their capital" – deleveraging – to regain the confidence of investors. The total effect of this will be to cut $2.6bn from the balance sheets of European banks, unless policy change is enacted to prevent it.

The pressure on each individual bank is to make as much from their shrinking balance sheets as possible, but the more this happens, the greater the risk that one bank falling over will take out others in a domino effect. In addition, around a quarter of the deleveraging would be achieved through shrinking the banks' supply of credit. The report estimates credit availability could fall by as much as 1.7 per cent.

José Viñals, the head of the IMF's Monetary and Capital Markets Department, said:

So far, current policies have prevented a ‘credit crunch’, but if financial stress intensifies a large scale and synchronized deleveraging by European banks could do a serious damage to asset prices, credit supply and economic activity in Europe and beyond.

The fund recommended a number of policies to Euro-area governments, including yet more easing from the European Central Bank, efforts to restructure and resolve weak banks, and a reinforced firewall (the European Financial Stability Facility and its successor, the European Stability Mechanism). With these policies in place the total balance sheet reduction will be "only" $2.2bn, or 6 rather than 7 per cent of total bank assets.

The motivation to act will be reinforced by international pressure, since the IMF identifies multiple risks that fall outside the Eurozone. Since much American banking actually flows through Europe, for instance, a credit crunch on the continent will hurt availability in the States. The US has its own house to keep in order, however, since the fund warns that the high deficits the country is running risk instability unless it adopts a fiscal plan which protects growth while still reassuring the market that debt will be brought down in the medium to long term.

Finally, the report provides a potential explanation for the continually low bond yields being experienced by both Britain and the US, writing that:

The number of sovereigns whose debt is considered safe is declining – taking potentially $9tn in safe assets out of the market by 2016, which is roughly 16 per cent of the projected total.

With trillions of dollars of safe assets unavailable, investors are forced to buy into the few remaining sovereigns still considered safe, which includes us and the US, despite the unfeasibly low yields (below inflation, in many cases) being offered on them.